Investors are heading into 2014-15 with Wall Street at a record high and volatility almost at a record low. The ­buzzword for conditions is “benign" and the Reserve Bank of Australia hasn’t flinched from its on-hold mantra in spite of concerns about consumer confidence.

The IPO market has roared back to life, and spectacularly cheap credit on offer from the bond market have created opportunistic conditions for merger and acquisition activity which could define the year ahead. Already
David Jones
,
Treasury Wine Estates
and
Australand
have fended off or embraced suitors, and more action is expected to come, with private equity re-emerging as a force to be reckoned with.

But in the background, a constant tension has emerged among experts over valuations in the Australian market, which stand at around 15.1 times forecast earnings, above its historic average. Investors spent most of the year asking whether the rally can keep running – and the question still stands.

The Australian benchmark S&P/ASX 200 ended 12.35 per cent higher at 5395.7 points in the year to June 30 with $168 billion added to the value of the top 200 companies taking the total to $1.7 trillion.

The five biggest banks, BHP Billiton and Telstra led the market. QBE Insurance Group, Coca-Cola Amatil, and GrainCorp were the heaviest laggards.The Australian dollar finished 2 per cent higher after tracking in a band between a high of US97.08 cents in October and a low of US86.84 cents in January.

Australian shares are expected to move 11.5 per cent higher in the next 12 months helped by central bank stimulus and the willingness of investors to put their faith again in mining stocks.

The standouts this financial year have been companies which delivered in defiance of an economy growing at a below-trend pace such as
SEEK
and
CSR
.
Commonwealth Bank of Australia
cracked $80 a share and it wasn’t even the best performing bank stock in the index: those honours belong to
Bank of Queensland
.

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BT Investment Management head of equity strategies Crispin Murray said the absence of hubris gave him some confidence that valuations were reasonable and exuberance was in check. “You have to keep in mind how cynical the market is," he said. “That gives me some encouragement people are still quite rational and wary on equities." Critically, what might look like a high average price-earnings ratio for Australian shares relative to historical trends is not nearly as acute in the context of record low interest rates.

“If we take an 18-months type of view. . . the market’s reasonably well underpinned. I wouldn’t call it cheap, the rating is consistent with the low level of interest rates we’ve got," Mr Murray said. “I don’t expect interest rates to go up any time soon. The level of earnings downgrades is actually reducing so there are less downgrades than we’ve seen in previous years."

Credit Suisse equity strategist Hasan Tevfik emphasised the unique combination of low funding costs and its relationship with company balance sheets. “The most unusual thing in markets right now is companies are getting recession level cost of debt at the same time as cashflows are recovering," he said. “Recession level cost of funding plus recovering cashflow equals M&A. . . When financing is so cheap it’s easy to do an EPS accretive deal."

Winning streak for bonds

While bonds themselves are on an indiscriminate winning streak, the booming sharemarket in the first-half of 2013-14 was hard to ignore.

Equities have been a sound investment, returning 12.35 per cent before dividends.

Telstra raised its interim dividend to 14.5¢ a share for the first time in eight years and the banks held their nerve inching incrementally higher with payouts thanks to low loan losses and an absence of credit growth.

That has kept the yield trade alive as investors search for income as well as a place to park their capital.

BHP Billiton
set the wheels in motion for a $20 billion spin-off of its non-core assets which could represent the biggest new entry into the ASX this year if the newly split group ends up being handed back to shareholders. The ­capital markets returned with a bang and then a whimper, serving up new stocks from
Freelancer
, which more than doubled on debut, to
Pact Group
, which failed to sustain its December offer price.

However, it is the Australian dollar that was probably the past year’s biggest losing trade as most strategists wrongly anticipated it would fall against the greenback. It got no further than US86.84¢ in January before traders realised the RBA was done cutting rates and interest in Australian government bonds with their triple-A ­status returned.

‘Perfect storm’

Macquarie foreign exchange strategist
David Forrester
said the currency had experienced a “perfect storm" and of the three biggest risks to its value at the end of 2013 – being the Federal Reserve rushing to raise rates, more RBA easing and a China shock – only one of those remained a threat and that was the outlook for China. “You do still have concerns around China and that’s a potential downside for the next few months," Mr Forrester said.

“In the interim basically you’ve got the carry trade going on. There’s been a return to interest in Aussie dollar assets. . . buying Australian sovereign debt and also interest in real assets like toll roads.

Is it sustainable? I think it is while we have such low volatility in markets."

The European Central Bank made history by sending deposit rates into negative territory in June, becoming the first major central bank to do so as Europe addressed the threat of deflation with a new rescue package.

Fed chair
Janet Yellen
’s big test will come as the case builds for interest rates in the US to rise from zero for the first time since the financial crisis, an event that could unsettle the prevailing calm. “Will she follow the path of
Ben Bernanke
and
Alan Greenspan
and potentially leave rate hikes too late and lead us into another asset price bubble?" asked Mr Forrester.

“We’ve had three financial crises in the past 10 years. . . two of those can be to an extent attributed to the Fed hiking too little too late."